Investors enjoy the greater tax efficiencies offered by exchange traded funds, but not all products are created equal. Specifically, master limited partnership ETF investors need to be aware of special tax considerations that could affect returns.
Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory, warns that most MLP-related ETFs are structured as C-Corporations, reports Catherine Cowdery for Bloomberg.
MLP ETFs that hold more than 25% of their portfolio in MLPs are structured as C-Corporations in order to track an underlying MLP-related index. Due to the C-Corporation structure, they must pay corporate income tax on distributions before passing them to investors. Consequently, MLP ETFs may incur higher fees that would cut into overall performance, leading to an underperformance compared to the underlying benchmark.
“Whatever you own shares of, one of those stocks – just a regular company, c-corporation, they will pay out dividends, and that’s ordinary income, or special dividends rate depending,” Iachini said in the article. “That’s a very standard, simple way to do business. But the drawback is those companies have to pay corporate income taxes.”
Consequently, some have aruged that ETFs like the Alerian MP ETF (NYSEArca: AMLP), which tracks the Alerian MLP Index, come with high costs. AMLP has gained 8.8% over the past year. [How MLP ETF Structures Affect Yields and Returns]
“Because the fund has corporate tax liabilities, its actual gross expense ratio is 4.85%,” according to Morningstar analyst Abby Woodham. “After taxes, AMLP is one of the most expensive ETPs on the market.”
MLPs are publicly traded partnerships known for their “pass-through” feature that helps investors generate stable, predictable cash flows. Investors, though, are required to pay income taxes in states where the MLP operates and have to report taxes on the K-1 form.
With MLP ETFs, investors won’t have to bother with the K-1 form and will have to fill out the normal form 1099.
Additionally, there are a number of MLP exchange traded notes, which removes the corporate-level taxation problem and may better reflects the full performance of the underlying index. The ETN, though, is an unsecured note issued by an underwriting bank, so investors are subject to credit risk of the issuing bank, The note is taxed as ordinary income.
For example, the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ), which also tracks the Alerian MLP Index, has outperformed AMLP’s return by over three percentage points in one year, gaining 12.1%. [MLP ETFs Capture U.S. Energy Expansion]
For more information on master limited partnerships, visit our MLPs category.
Max Chen contributed to this article.